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Rumours of my death are greatly exaggerated

Mark Twain’s famous misquote concerning his alleged death bears great parallels with value investing today. We have seen almost 10 years of value style headwinds since the global financial crisis and many observers have been calling time on this much maligned investment approach, particularly after the worst year on record for value investing in 2017. At Eastspring Investments, we have kept the faith through the toughest of times and we believe there is more evidence today not just for value’s survival but for its continued long-term dominance.

Andrew Cormie Portfolio Manager, Equity

Sep 2018

Fig 1: Value outperforms over the long run but has underperformed over recent years1

Since the back end of the global financial crisis in 2008 equity investors have been very much focused on certainty and reduction of risk. Equity investors have sought (an illusion of) certainty presented by stable historic corporate earnings streams, promises of continued dividend payments or extrapolation of higher profit growth, while the price paid has become, at best, a secondary consideration. The structural bias of Global Emerging Market (GEM) equity managers towards a quality/growth approach has driven these stocks’ prices higher and helped these styles outperform the market and value, but the accompanying momentum has driven some stock specific valuations to extremes. This emotional herd behaviour is the very essence that creates value opportunities.

Over the last few years investors have been asking if or when this emotionally-charged juggernaut will turn, and question marks have been raised over value as a resilient investment approach. Questions have been asked whether the drivers of investment returns have changed, and that new technologies, new industries, new economies and new politics mean a value approach, which has delivered over time, is no longer relevant. We don’t think so. Our belief in value investing is anchored around human behaviours and the lopsided emotional reactions we all have, to fear and greed. Humans are wired to overcompensate for the feeling of comfort because the emotion we feel for an equal amount of discomfort is many times amplified – otherwise known as loss avoidance. If anything, the prevalence of these ‘new’ regimes creates more uncertainty and opportunity as most investors flock to the comfort of the popular ‘known’ investment stories to assuage emotions rather than focus on price dislocation.

We have always remained true to label and from a value investor perspective 2017 was relentlessly demanding. Not only did the most popular stories and most expensive stocks at the start of the year outperform over that year, but the GEM equity market performance was dominated by just one sector – technology. Investors believed in the story, the theme and the hype, and many technology companies delivered solid results which fed the fervour. Prices of these popular tech names begun to reflect perfection in perpetuity. We challenged our models, our valuations and our thesis and could not see any value signals in the popular names at the start of 2017 (see Fig.2).

Fig 2: Valuation of the popular Chinese technology names at the start of 20172

2017 turned out to be the worst year for value in the last 20 years, with MSCI EM Value Index underperforming its core benchmark by 9.2% for the year. Looking around us we could see clearly where our value peers sat and that we were lonely participants. Many GEM peers performed very well as they took advantage of the price momentum. And the value doubters grew more confident as rumours of the death of value were uttered.

By the end of 2017 GEM equities were still attractively valued relative to developed markets and headline valuations had become fairly-valued, but the valuation dispersion with GEM equities was at extremes. Some of the quality/growth stocks had reached valuations that looked unsustainable in our view (see Fig.3) and this strengthened our resolve. The gap between this expensive narrow segment of the market and the value end of the market had grown to levels not seen for 20 years (see Fig.4).

Fig 3: The popular expensive names at the end of 20173

Fig 4: EM quality stocks are extremely expensive relative to value4

Value started off 2018 with fewer disciples than ever as the morbid rumours continued to circulate. However, it seems to have been premature. There has been a raft of what some commentators have described as “fallen angels” where popular stocks have risen to very high valuations on the back of comforting thematics and extremely high expectations but they have not been delivering. In Chinese technology we have seen internet name Tencent, which had become a default ‘top 10’ holding of most GEM Funds, fall 16% year to date as they have failed to hit stratospheric profit expectations. Elsewhere in China we have seen other popular technology names that had risen on the thematics and the promise of perpetual profit growth falter: Netease has fallen 43%, YY is down 32% and JD.com is down 24% year to date. In Korean cosmetics stocks, where we have seen valuations touch the heavens on the back of extrapolated profit growth driven by the easily digested Chinese consumer demand story, a number of issues including geopolitics and missing optimistic profit targets have hit the share prices hard as the story unfolded. Also in Korea there have been examples of popular thematic stocks, such as biotech research company Celltrion which, despite very little revenues to date, has been elevated to a PE of 85.6x and a PB of 13.6x at the end of August on the back of potential advances in the treatment of cancer. This remains an extremely popular and expensive stock on a PE and PB basis that does not make it through our objective valuation screens (see Fig.5).

Fig 5: Performance of some popular expensive names at the end of August 20185

The ‘new’ regimes continue to create uncertainty and a few less-than-perfect outcomes for expensively-priced popular themed companies have led to some aggressive price corrections. We have now seen some of the most expensive names underperforming significantly this year as investors have begun to question their long-term view of tech nirvana and digest the reality of competitive market dynamics.

GEM Value as defined by MSCI has now outperformed year to date to end August by 1.4% and we have also seen our GEM value strategies outperform over the last few months, and are now ahead year to date and over 1, 3 and 5 years. Value stocks tend to correct hard and fast and recent months have been good examples of that beginning. Investors tend to move quickly to re-set their expectations and valuations from extremes so being a follower in the style shift is impossible.

We strongly believe that there is a great value opportunity today in GEM equities but also that value retains its validity as a strategy to outperform over the long term. The structural tailwind for value is highly resilient as human behavioural biases are hard-wired and hence following a disciplined value approach can offer investors both strong risk adjusted performance and diversification benefits.

Interesting reads

Source:
1Eastspring Investments, as at 30 June 2018. Market cap weighted. Market-relative performance of respective style indices (quintile 1 minus benchmark), rebalanced on a monthly basis, from 31 December 1999. The index described is unmanaged and not available for direct investment. Please note, there are limitations to the use of such indices as proxies for the past performance in the respective asset classes/sector. The historical performance or forecast presented in this slide is not indicative of, and should not be construed as being indicative of, or otherwise used as a proxy for the future or likely performance of the Strategy.2Thomson Reuters DataStream, as at 31 December 2016.3Thomson Reuters DataStream, as at 31 December 2017.4Macquarie Quantitative Research, as at 31 July 2018. Relative PE (price-to-earnings) of quality versus value stocks and growth versus value stocks in Emerging Markets. EM = Emerging Markets. SD = standard deviation.5Thomson Reuters DataStream, as at 31 August 2018. Ytd = Year to date.

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